Weird Science 101!

By

Richard Karp

Updated March 1, 1999 12:01 a.m. ET

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I t took 33 years of hard work for Dan Scrocco to build a successful chain of six service stations in northern New Jersey. But today, Scrocco isn't checking gas pumps or car lifts. Instead, he's sitting in a "trading salon" run by the All-Tech Investment Group, his eyes glued to the stock quotes on a computer screen. He's trading against the market-makers, minute by minute, hour by hour, in and out. So profitable has been this new enterprise that he's sold three of his stations and has the others on the block. In short, he's become a devotee of America's newest craze: day trading.

No one knows how many day traders there are in the U.S., but the figure is probably in the tens of thousands. Some are lured by ads from brokerage schools that promise to teach everything needed to be a winner. Others are simply stock-market junkies. And some come because they're serious investors who can think of nothing more thrilling than making a living doing what they love best. In any case, many of them are ardent proponents of momentum investing, who focus only on the hottest equity sectors. Indeed, many Wall Street pros blame day traders for the volatility that repeatedly has rocked Internet stocks -- and the market as a whole.

The road that led Scrocco to the little desk he's perched behind in Montvale, New Jersey, began around 1995, when he installed a computer in one of his service stations and, via the Internet, began buying and selling stocks through
E*Trade
. Like other online brokerages back then, E*Trade displayed quotes, but not the "Level II" universe of bids and offers from other market-makers in a particular stock. "Which meant," Scrocco explains, "that I punched in a bid to E*Trade, and the brokers there would execute the trade." In effect, not much different from telephoning a broker with a buy bid, and having him dicker over the actual execution price with a market-maker, who profits from the spread between the bid and offer.

But no matter, as far as Scrocco was concerned. He spent two years learning the ropes of computerized trading, getting a feel for the market's pulse and making a nice, steady profit. Then came the sickening but short-lived market plunge of October 1997. With prices skidding, he wanted to jump on his three favorites --
Microsoft
,
Dell Computer
and
Intel
-- in the hope of riding them back up again for a fat profit when the market revived. No dice. The phone lines to E*Trade were down, apparently swamped by offers and bids during the three-day panic. By the time he got through, the market was back up -- and so were the prices of his picks.

Then the frustrated Scrocco heard about All-Tech, one of dozens of registered brokers around the country that promise retail online traders direct, uninterrupted access to Nasdaq's computers, which display all market-makers' bids and offers on a particular stock, and allow traders to punch in, or hit, the best buy or sell price for up to 1,000 shares; which the market-maker, by National Association of Securities Dealers rules, must instantaneously execute -- even if there's little or no wiggle-room to create a spread profit.

The electronic link that All-Tech used is known as the Small Order Execution System, or SOES. In fact, SOES was at one time the very soul of day trading (that's changing; more on this later), and many market-makers -- who call day traders "SOES bandits" -- would love to see it blown up.

Dan Scrocco attended an All-Tech promotional seminar, liked what he heard, and plunked down the required $5,000 for All-Tech's four-week course. Among his subjects: how to spot technical trends, how to glean momentum from the flickering numbers and, of course, how to hit cheap-looking bids. The goal: to ride stocks up a quarter-, half- or full-point -- and quickly punch out of the position with a profit. Not exactly the kind of thing that Warren Buffett favors. But precisely what day traders dream of.

In January 1998, Scrocco began trading daily with 30 or 40 other customers at All-Tech's Montvale headquarters. (The brokerage has several other "trading salons" around the country and some 1,500 customers.)

The price of admission to the trading area is a minimum $50,000 account (which, through the use of margin, can be leveraged up to bring the initial stake to $100,000). Each trade costs $25, and to encourage trading, All-Tech rebates $5 for each buy or sell order. The maximum cumulative rebate is $5,000 -- which means that a client can earn back his tuition, but only if he generates lots of fees for All-Tech in the process.

Scrocco, who lost money for six months after he got into the fray, says that "in the past six months, trading has been very good, and I'm making more money than I made at the gas stations."

One of his rules is to "trade only a limited number of stocks in my day trading account, maybe around six. These are fast movers, and I don't want my attention taken away by trying to follow the whole stock market."

Scrocco isn't like most All-Tech customers, who close their positions at the end of each day and go home "flat" to avoid staying awake worrying all night. He keeps an account for long-term investments.

Also, unlike the true lone wolves who like to joust with the market from a home computer (for an additional $250 monthly connection charge), the gas-station owner prefers to work from within All-Tech's humming confines.

"For one thing," he explains, "there's much more face-to-face access to information and support here. If you buy too much of your stock and it goes down and you get a margin call, you know the people in the margin department, and they can help you right away." And, he continues, "there are guys here who have worked on Wall Street, and they've taught me a lot."

Another All-Tech client is Andrew Lias, who ran the parts department at a Long Island Harley-Davidson dealership until becoming a day trader four years ago. "I do okay. I'm not a millionaire, but I make a comfortable living,' he says. How comfortable? From January 1 [through January 26], "I made a profit of $40,000," he answers, without the trace of a boast.

Of course, such sums can easily be lost if the market moves against a trader for a sizable stretch. And the vast majority of people who take All-Tech's day trading course don't make a buck buying and selling shares.

Indeed, the firm's blunt-spoken chairman, Harvey Houtkin, concedes that two-thirds of his customers, who have plunked down $5,000 for his training course and another $50,000 minimum of risk capital to open a trading account, lose money and vanish from the scene in a matter of months.

"The markets will clean you out if you don't know what you're doing," he observes, making it clear that most would-be day traders don't know which end is up.

The winner, Houtkin adds, is "the guy with entrepreneurial spirit, who knows about hard work and the value of the dollar, not a doctor who has a pile of money, but never had to bootstrap. The market has no remorse."

Bill Lauderback, the head of marketing for Houston-based Momentum Securities, a day trading specialist with 10 offices around the country, says that being a quick study helps, too. Successful day trading, he observes, "requires the ability to absorb a great deal of information very quickly, and the ability to analyze it all very quickly."

Marc Friedfertig is the managing member, as he entitles himself, of Broadway Trading, an outfit in the heart of New York City's financial district. Friedfertig emphasizes that "day trading is not a get-rich-quick scheme," even though, he contends, "the media has hyped this thing. It's true that people are making fortunes -- but it's not easy."

Observes Andrew Lias of his experiences at All-Tech: "Most people I've seen here don't make it; it's not for everyone. The people who have failed are those who can't take risk. I've seen people who had nervous breakdowns when their stock dropped a half-point. Other failures are the guys with big egos, who refuse to get out of a falling stock. You have to be thick-skinned, because the market doesn't care about your rent bill."

And, he adds, quick success can raise dangerously unrealistic expectations. "If they start off like they're 'taking candy from a baby,' they fall apart when things start moving against them," Lias says.

Says Nancy Torraco, another All-Tech client: "Most people who get hurt take a bad position home, in the hope that it will rebound the next day. That's not the way of day trading."

An important aspect of this subculture is the shifting regulatory and technological environment surrounding it.

In 1997, the Securities and Exchange Commission approved a rule change that allowed market-makers to reduce the minimum obligation mandated in their posted quotes from 1,000 shares to 100, thereby cutting to a fraction the play the SOES bandits had been accustomed to hit.

The rule change, which became effective late last year, has dramatically reduced the amount of day trading done via the Small Order Execution System.

Momentum Securities' Lauderback says that "less than 5% of our trades are executed on SOES" now. And All-Tech's Houtkin, who likes to call himself the "original SOES Bandit," acknowledges that SOES, as a vehicle for his customers' day trading, now reflects no more than 25% of their trading volume.

But SOES isn't quite dead and day trading, thanks to a newer system whose features embody a compromise between the clashing interests of traders and market-makers, has become more and more popular.

That system, developed to allow institutions to trade anonymously, is among those commonly called Electronic Communications Networks, or ECNs. It lets a day trader compete for any Nasdaq stock, not only with a market-maker, but with any other trader in the world who puts a bid or offer quote on his ECN-connnected computer.

Asserts NASD spokesman Michael Shokouhi: "It's become more profitable for day traders to use ECN, because it's faster than SOES. ECN has fresher quotes. Day traders used to hit stale quotes on SOES, and turn around and sell on the ECN quote," in effect practicing a form of arbitrage.

However, All-Tech's Houtkin maintains, in using ECN, "you're going in between the spread." For example, 'if a market-maker posts a bid of 23 1/4 and another market-maker is willing to offer at 23 1/2 , you go in at 23 3/8 -- right between the spread. In this way," he observes, "the market-maker may make some money, but not as much of a profit as he traditionally did."

On the other hand, Houtkin adds: "If you're bullish on a stock, you can put a bid on Nasdaq that is better than the market-makers' posted prices. So if a market-maker's current bid is 23 1/4 , you can bid at 23 5/16. So you get a seller before the market-maker does -- at no spread cost to you."

Regardless of the venue, one thing seems certain: Most people who try their hands at day trading don't succeed, while a much smaller group has the right stuff to generate a handsome livelihood plying this somewhat arcane trade. And for the winners, the best benefits won't necessarily be purely financial. Says one full-time trader at All-Tech, Robert Pirrello of Bedford, New York: "If you make $500 or $1,000 early in the day, you can go home and play golf. That's beautiful." Especially compared with losing that much money and having nothing to do for the rest of the day but to keep trying to outwit the flashing screen.

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